Finance management cengage 2013 chapter 02

Financial Markets and InstitutionsThe Capital Allocation Process Financial Markets Financial Institutions Stock Markets and Returns Stock Market Efficiency Chapter 2... The Importance of

Financial Markets and Institutions

The Capital Allocation Process

Financial Markets Financial Institutions Stock Markets and Returns Stock Market Efficiency

Chapter 2

The Capital Allocation Process

• In a well-functioning economy, capital flows

efficiently from those who supply capital to those who demand it

• Suppliers of capital: individuals and institutions

with “excess funds.” These groups are saving money and looking for a rate of return on their investment

• Demanders or users of capital: individuals and

institutions who need to raise funds to finance their investment opportunities These groups are willing

to pay a rate of return on the capital they borrow

How is capital transferred between savers and

borrowers?

• Direct transfers

• Investment banks

• Financial intermediaries

What is a market?

• A market is a venue where goods and services are

exchanged

• A financial market is a place where individuals and

organizations wanting to borrow funds are brought together with those having a surplus of funds

Types of Financial Markets

• Physical assets vs Financial assets

• Spot vs Futures

• Money vs Capital

• Primary vs Secondary

• Public vs Private

The Importance of Financial Markets

• Well-functioning financial markets facilitate the

flow of capital from investors to the users of capital

saved/invested, which provide them money in the future.

– Markets provide users of capital with the necessary funds to finance their investment projects.

• Well-functioning markets promote economic

growth

• Economies with well-developed markets perform

better than economies with poorly-functioning markets

What are derivatives? How can they be used to

reduce or increase risk?

• A derivative security’s value is “derived” from the

price of another security (e.g., options and futures)

• Can be used to “hedge” or reduce risk For

example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens

• Also, speculators can use derivatives to bet on the

direction of future stock prices, interest rates, exchange rates, and commodity prices In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong

Here, derivatives can increase risk

Types of Financial Institutions

• Investment banks

• Commercial banks

• Financial services corporations

• Credit unions

• Pension funds

• Life insurance companies

• Mutual funds

• Exchange traded funds

• Hedge funds

• Private equity companies

Physical Location Stock Exchanges vs Electronic

Dealer-Based Markets

• Auction market vs Dealer market (Exchanges vs

OTC)

• NYSE vs Nasdaq

• Differences are narrowing

Stock Market Transactions

• Apple Computer decides to issue additional stock

with the assistance of its investment banker An investor purchases some of the newly issued

shares Is this a primary market transaction or a secondary market transaction?

– Since new shares of stock are being issued, this is a primary market transaction

• What if instead an investor buys existing shares of

Apple stock in the open market Is this a primary or secondary market transaction?

– Since no new shares are created, this is a secondary market transaction

What is an IPO?

• An initial public offering (IPO) occurs when a

company issues stock in the public market for the first time

• “Going public” enables a company’s owners to raise

capital from a wide variety of outside investors

Once issued, the stock trades in the secondary market

• Public companies are subject to additional

regulations and reporting requirements

S&P 500 Index, Total Returns: Dividend Yield +

Capital Gain or Loss, 1968-2010

Where can you find a stock quote, and what does

one look like?

• Stock quotes can be found in a variety of print sources

(The Wall Street Journal or the local newspaper) and

online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral)

Stock Quote for GlaxoSmithKline, July 11, 2011

Highly Inefficient

Highly Efficient Small companies not followed by

many analysts Not much contact

with investors.

Large companies followed by many analysts Good communications with investors.

What is meant by stock market efficiency?

• Securities are normally in equilibrium and are “fairly

priced.”

• Investors cannot “beat the market” except through

good luck or better information

• Efficiency continuum

Implications of Market Efficiency

• You hear in the news that a medical research

company received FDA approval for one of its products If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock?

– No If the market is efficient, this information will already have been incorporated into the company’s stock price So, it’s probably too late for her to

“capitalize” on the information

Implications of Market Efficiency

• A small investor has been reading about a “hot” IPO

that is scheduled to go public later this week She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading Would you advise her to do this?

– Probably not The long-run track record of hot IPOs

is not that great, unless you are able to get in on the ground floor and receive an allocation of shares

before the stock begins trading It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading.